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Understanding the Role of Financial Constraints in the M&A Market

Professor Andrey Malenko

A decision to expand by acquiring another business is one of the important decisions that a firm’s stakeholders make. Consider a mature firm, such as a big pharmaceutical company, contemplating an acquisition of a growing company, such as a small biotech firm. This decision has three aspects to it: (1) whether to initiate a bid for the target now or later; (2) how much to bid; and (3) what form should the bid take (cash, stock of the combined firm, or more exotic forms). In a recent research paper, Alexander Gorbenko from London Business School and I develop a theoretical framework to analyze how these decisions are interconnected. Within this framework, we explore a number of research questions. First, what role does bidders’ ability to pay in cash play in acquisition activity? The M&A activity has experienced a boom-and-bust pattern, and our goal is to understand whether fluctuations in financial constraints of the bidders could be linked to these dynamics. Second, what determines whether the firm gets acquired, and if it does, at what stage of its life-cycle does it occur? In particular, how are acquisitions of small targets different from acquisitions of targets that have already grown? Finally, how do deals done in cash and in stock differ?

In the perfect world with no frictions, bids in cash and in stock would be equivalent both for the bidder and for the target. If both parties agree on the monetary value of the bid in stock, there is no difference between getting paid in stock and getting an equivalent payment in cash. This is no longer true in the presence of information asymmetries between the bidder and shareholders of the target. To see why, consider the following simple numerical example. Suppose there are two bidders, A and B, who compete to acquire company X. Both bidders have assets in place worth of $100, but differ in their ability to add value to firm X. Specifically, firm X will be worth $25 if it is acquired by A, and $100 if it is acquired by B. These values are private information of each bidder.

Suppose that A and B compete by making cash bids in an open ascending-bid auction. Then, A is willing to bid up to $25 – the price at which A breaks even. Similarly, B is willing to bid up to $100. As a consequence, B wins the auction and acquires X for $25 – the price that A is no longer willing to increase. Now, instead, suppose that A and B compete by making bids in the form of stock of the combined company. In this case, A  is willing to offer up to 20% of the combined entity – this is the offer at which shareholders of A are indifferent between owning the remaining 80%  of the combined firm worth $125 and owning 100%  of the stand-alone firm A worth $100. By a similar logic, B is willing to offer up to 50% of the combined entity. As a result, B acquires the target and pays the maximum bid of A, which is 20% of the combined entity. The value of this bid is $40 (20% of $200), which is 60% higher than $25 that B would pay if it bid in cash.

By this reasoning, the ability of bidders to pay cash helps bidders to pay less and hence capture more value from acquisitions. Does it imply that more cash-constrained bidders make fewer acquisitions? It turns out that not necessarily. In particular, the answer depends on whether the bidder is expected to stay cash-constrained for a sufficiently long time, and how high its synergies with targets are. To see why, consider, first, a transitory negative shock to cash constraints: Suddenly, a bidder is no longer able to pay its bids in cash, but it is expected to become less constrained in the near future. In this case, it clearly benefits from postponing bidding for the target until financial conditions get better. Thus, a short-term tightening of cash constraints indeed reduces acquisition activity.

Instead, consider now a permanent shock to cash constraints: Suddenly, a bidder is no longer able to pay its bids in cash, and it is expected to stay constrained until, perhaps, distant future. Or, equivalently, consider a bidder that is constrained because of the nature of its ownership, for example, if it is a private company. In this case, postponing bidding can be less beneficial for the constrained bidder than for the unconstrained bidder. Intuitively, by acquiring the target while it is still small, the bidder can capture a higher fraction of surplus generated in the takeover. This is because by how much bidding in stock is more expensive than bidding is cash depends on how large the target is. If the target is small, there is little difference between cash and stock bids. This is not the case if the target is large, when stock bids can be considerably costlier than cash bids. In the example above, if the target were twice bigger, the winning cash bid would be $50, but the value of the winning stock bid would be $100.[1]

Thus, when deciding whether to bid for a target a constrained bidder faces the following trade-off. On one hand, bidding in stock generates less value than if the bidder were unconstrained. This factor discourages the bidder from bidding. On the other hand, there is a benefit to acquiring the target preemptively, while it is still small, which encourages the bidder to bid. We show that the latter effect dominates if the target grows very quickly and if synergies that a bidder realizes from acquiring the target are large enough. If one of these two conditions does not hold, the former effect dominates, and permanent cash constraints discourage acquisitions.

Our analysis implies that “mega-mergers” are rarely successful for shareholders of the acquirer. This happens due to a combination of two factors. First, because such deals are so large, even the most unconstrained acquirers bid, at least partially, in stock. However, bids in stock make it hard for the acquirer to capture value in the deal if the target is large. Second, such deals tend to be low-synergy, simply because if they were high-synergy, they would have happened in the past.

The analysis also has implications for the relation between means of payments in a deal, total value created in it, and the split between the acquirer and the target. Empirically, acquisition premium in deals done in stock is on average lower than in deals done in cash. This is consistent with our theory. Intuitively, high-synergy targets are acquired early when they are still small. Because they are small, acquirers can usually afford paying cash for them. In contrast, low-synergy targets are acquired, if at all, after they grow enough, in order to outweigh the cost of doing the deal. Because such targets are large, bidding in cash is often not an option for acquirers, so such deals are often done, at least partially, in stock. Thus, cash deals tend to be high-synergy, while stock deals tend to be low-synergy, so average premium paid in cash deals is often higher than in stock deals, despite the fact that a bidder in any given deal may find it more expensive to pay in stock.

Andrey Malenko is an Assistant Professor of Finance at MIT Sloan School of Management.

[1] A offers up to 50/100+50 of the combined company. Hence, the value of B’s winning bid is 50/100 ($100+$200) = $100. Hence, the value of the winning stock bid would exceed the winning cash bid by 100% , not by 60% , as before.